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  • Writer's pictureMark Watson-Mitchell

Slumping UK small caps should be ‘first in, first out’ as valuations turn exciting - Citywire

As a UK smaller companies investor it helps to have a strong stomach, according to Martin Currie fund managers Dan Green and Richard Bullas.

That has certainly been the case this year, especially after steep losses for small and mid-cap indices accelerated in last week’s turmoil. That has left the FTSE 250 approaching deep value territory, according to some commentators.

In hard numbers, the Numis Smaller Companies ex-Investment Companies and FTSE 250 ex-Investment Trusts indices are both down more than 25% in 2022. By comparison, the FTSE All Share, representing the wider UK market, has fallen only 7.9%, as larger companies have proved more resilient, particularly in the commodities sector.

Bullas and Green, who manage the Franklin UK Mid Cap and UK Smaller Companies funds, respectively, have seen their returns take a hammering as well, but believe the market bottom is near, at which point there will be a lot of ‘exciting opportunities’. The pair said small and mid-caps are often the first into a downturn, but also the first out. Speaking at a Franklin Templeton investor event, they pointed to examples of strong performance following severe market downturns, such as the onset of the Covid pandemic in March 2020.

‘When the market bottoms, your average return over the past three or four recessions has been between 15-20%. It’s first in and first out. This lull in performance now is leading to valuations that are looking extremely attractive,’ said Bullas (pictured below), who took over as lead manager from Paul Spencer in July 2020. He emphasised that the drawdown, or the decline from peak to trough, of the FTSE 250 versus the FTSE All Share, has surpassed all of the major market downturns over the last 15 years, which indicates the recovery potential.

‘This drawdown we’ve seen versus the FTSE All Share has now surpassed the Covid selldown we saw in March 2020, albeit quite short and sharp, and it now surpasses the Brexit drawdown that we saw in June 2016 and the drawdown of the global financial crash of 2007-2008,’ Bullas said. After a short-lived summer ‘bear market’ rally for most equity markets burnt out, UK small and mid-caps have taken a fresh battering. Since 15 August, the Numis small-cap index has fallen 13.7% while mid-caps are down 17.1%, according to Morningstar data. Over that time, Bullas’s fund has fallen 18.3% and Green’s smaller companies fund 13.6%. However, based on past experience, they could bounce back as fast as they fell. Green (pictured below) compared the current stage of the market to the final set of lights before a Formula One race begins. Other managers in the space echoed the view that overwhelmingly negative sentiment can see valuations become much too cheap and quickly give way to a sharp reversal. James Henderson, manager of Henderson Opportunities Trust (HOT), referenced the extremely negative tone he had picked up on at a couple of investment conferences last week. Anecdotally, the UK has even started to be compared to an ‘emerging market’ as investors lose faith in the government’s economic management. ‘When the Americans start to say the UK has become “uninvestable”, that could be a sign the bottom is coming,’ said Henderson. His UK All-Companies trust has fallen heavily this year, with the shares down 29.6%, according to broker Numis Securities.

Discounts widen, stocks cheapen

Negative investor sentiment on investment trusts which focus on UK smaller and medium-sized companies is reflected in their wide discount, such as HOT’s 16.1% discount to net asset value (NAV).

The NAV of JPMorgan Mid Cap (JMF), reflecting underlying investment returns, has fallen 40.1% year to date, and the trust trades at a 12.6% discount. Larger peer Mercantile (MRC) and Schroder UK Mid Cap (SCP) are on 15.3% and 11.8% discounts respectively, according to Numis, although none of the pack are notably ‘cheap’ versus history, on the basis of analyst ‘Z-scores’.

The short-term picture does not tell the full story for the sector, where many funds remain strong performers over a 10-year period.

The Franklin UK Mid Cap fund has returned 85.2%, outperforming its benchmark by almost 10%. Green’s UK Small cap fund, 164%, outperforming by more than 60%.

It is difficult to distinguish these trusts on long-term performance grounds. JPMorgan Mid Cap’s shareholders have enjoyed the strongest 130% return over a decade, but stablemate Mercantile’s underlying returns have been better, with NAV rising 120%.

As the market continues to fall, Bullas and Green have tried to ensure their portfolios have net cash to weather the downturn. They said that is ‘a very strong position’ to be in ‘heading into buyers’ market’.

On the mid-cap fund, 57% of the portfolio has net cash, Bullas said, including his three property stocks, Bellway (BWY), Redrow (RDW) and Grainger (GRI), which have seen significant deratings recently. For the small-cap fund, 51% of the portfolio has net cash, according to Green.

‘That puts us in a fantastic position, not only to weather a downturn, but to continue to invest in the business for future returns and take the opportunity to build,’ Bullas said.

The mid-cap fund’s top positions include telecoms testing company Spirent (SPT), industrial good distributor RS Group (RS1) and outsourcing group Serco (SRP), which make up 14.3% of total assets, according to the company’s website.

‘We’re getting quite excited about some of the valuations, which we haven’t seen for a long time, and the prospective returns we can get in the medium to long term,’ said Green.

The small-cap fund’s top holdings include financial group Alpha FX (AFX), Videndum (VID), which specialises in video equipment and software, and alternative asset manager Gresham House (GHE).


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